The spike in inflation may hint at peak rates in emerging markets

Vladimir Zakharov

Emerging market (EM) central banks reacted to high inflation by dramatically tightening monetary policy, in some cases well ahead of the US Federal Reserve and European Central Bank. Today, after a difficult period, inflation in emerging markets seems to be easing, with policy rates approaching cycle highs. This takes real, or inflation-adjusted, interest rates above neutral policy rates and towards previous peak levels, potentially creating a more favorable investment environment.

After largely synchronized rate hike cycles in emerging markets, monetary policies could again start to diverge across countries. With real rates rising and valuations improving, we see more reason for optimism, although we remain cautious in anticipation of greater clarity on the Fed’s hike path, given the the excessive influence of US monetary policy on emerging markets.

Most emerging countries have recently recorded lower sequential monthly inflation figures. These are expected to continue to decline towards the end of the year as growth slows and after commodity price increases have recently eased, although the outlook for energy prices remains uncertain. This lower inflation path stems from the early up cycle in many emerging markets, such as Brazil and Chile, which started raising rates in 2021. In contrast, the Fed only started raising rates to rein in inflation than in March of this year.

For many investors, the discussion of emerging market policy is becoming more nuanced, moving from how high rates are to whether emerging market central banks can keep rates steady (albeit at elevated levels) then that the Fed continues to rise. In some emerging countries, such as Brazil, local curves have even started to set rate cuts until the end of 2023.

Real rates are now above the neutral – or equilibrium – level in most emerging countries (see chart 1). Going forward, with an expected decline in inflation, these real rates are expected to rise significantly as long as policy rates remain unchanged. This scenario looks increasingly likely as inflation expectations remain above many central banks’ inflation targets through 2023 in both emerging and developed markets.

Figure 1: Real rates are above neutral in many large emerging economies and close to previous cycle highs

This is a bar chart comparing real rates, previous cycle highs, neutral rates and real rates expected at the end of 2023 in eight emerging economies.  It shows that rates are above neutral levels and near previous cycle highs in Brazil, Mexico, Colombia and Hungary, while rates in Chile are above both neutral levels and previous cycle highs.  Rates are below neutral in South Africa, Indonesia and Poland.

That said, the trajectories of individual nations can vary widely, if not diverge. For example, real rates look set to decline in emerging economies such as Brazil and Chile, but remain elevated in others such as Mexico and Poland where core inflation has been much more persistent. . Here are four countries that illustrate the diversity of scenarios unfolding around the world:

  • Brazil: In the current monetary policy cycle, Brazil has been a leading example. The country’s central bank staged an aggressive hike cycle that left rates well above neutral. With inflation expectations now falling, the policy will be even tighter in real terms (and even higher than in the 2016-2017 cycle). The central bank should start a cutting cycle next year just to keep real rates where they are. Assuming no shock effect in the aftermath of the October presidential election, we expect Brazil’s central bank to keep rates unchanged over the next few months, with a cycle cutting starting in mid-2023.
  • South Africa: Inflation has never really reached such a high level, in part because of a generous inflation target of 4% which allowed the South African central bank to be patient in its upward cycle, with rates still not at neutral level. Fiscal policy did the heavy lifting with a more modest currency depreciation, given that the country is a commodity exporter.
  • Mexico: The country’s central bank will likely attempt to maintain a constant real spread to the US Federal Reserve’s key rate and keep pace with the Fed’s hike. Core consumer price index (CPI) inflation is still above the Mexican central bank’s target, the core components of inflation most linked to activity and wages remaining very high, so the rise with the Fed is in line with the internal dynamics of inflation in Mexico. We expect further hikes of 75 basis points (bps) and a policy rate of 10% by 2023.
  • Poland: Inflation is expected to remain well above target for much of next year. Policy rates are not yet neutral, which means that Poland is one of the countries that will probably have to tighten further.

Despite these country-specific factors, much of emerging markets still depends on the Fed’s own policy cycle and global risk environment. The Fed’s clarity on its path and the impact on the US dollar and global liquidity conditions will be key factors to watch that will inform political cycles in emerging markets. Looser financial conditions and a weaker US dollar would provide emerging market central banks with the possibility of a deeper rate cut cycle.

Overall, the signals seem more positive for emerging market local rate exposures. Emerging economies are not off the hook yet, but the balance of valuations, technicals and fundamentals (for more details, see our recent blog post, “Spot opportunities and risks in the emerging markets investment universe“) at the moment indicates a move towards positions that we currently favor, such as being long Brazil and short Poland.


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Carol N. Valencia